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December 28, 1990

The Effects of Interstate Banking
Since the late 19705, many states have enacted
interstate banking legislation, permitting bank
holding companies headquartered in selected
other states to operate bank subsidiaries in their
state. Bank holding companies (BHCs) are firms
that own at least one bank. Recent bills in Congress propose to liberalize interstate banking
laws further by permitting banks themselves to
operate their own branches across state lines.
Proponents of such legislation argue that further
liberalization would generate some significant
benefits. Among those benefits are a more efficient and stronger banking industry and re-invigorated competition in the commercial banking
market. Opponents are concerned that interstate
branching would lead to excessive concentration
and ultimately to a less competitive banking
The purpose of this Letter is to discuss the
possible benefits and costs of interstate banking
and branching and to present evidence pertinent
to those issues. The main benefit of interstate
provisions appears to be enhanced competition.
Therefore, interstate branching would likely not
lead to excessive concentration in the banking

Economies of scale and scope?
By increasing the size and scope of the market
in which banking organizations can operate,
interstate provisions may yield the benefit of
lower costs. Lower costs would come from
economies of scale or synergies gained by
an increased scope of activities.
Synergies of scope would arise, for example, in
a situation where affiliated banks (banks that are
subsidiaries of the same BHC) or branches of the
same bank benefit from one another's experience
in lending to different, but related, sectors of, say,
the high technology industry. Interstate banking
and branching would enhance banking firms'
abi Iity to take advantage of such synergies when
the sectors are centered in different states.
To determine whether these potential benefits
are real, one must determine whether there even

is any relationship between efficiency and size
or efficiency and the scope of activity in banking. The structure of costs at banks has been the
subject of numerous studies that have, in general,
concluded that economies related to scale or
scope are relatively small. They suggest that one
must look elsewhere for any benefits from interstate banking and branching.
Elsewhere may be the effectiveness of
management. Economists Allen Berger and
David Humphrey used actual average costs for
all insured commercial banks in 1984 to estimate
the contributions of various factors to differences
in those costs. They estimated differences of 25
percent or more in average costs between the
highest and lowest cost groups of banks due to
inefficient management, and differences of only
5 percent or less due to scale or product mix.
Their findings suggest that effective management is important for cost savings and that there
is room for improvement in the efficiency of
bank management. To the extent that interstate
banking and branching increase competitive
pressures on banks by increasing the number
of competitors that each bank faces, they may
help increase efficiency by forcing management
changes and reforms for banks of all sizes.

Enhanced competition?
Another possible benefit of interstate banking
and branching may be an increase in the competitiveness of previously protected banking
markets. For example, banking firms may enjoy
above-normal profits in a state whose boundaries
define an area that accommodates only a limited
number of "efficient"-sized banking firms. To
the extent that enlarging the area within which
banks can operate increases the threat of competitive entry, interstate banking and branching
may enhance competition.
Some banking observers are concerned that the
mergers and acquisitions facilitated by interstate
banking or branching could lead to fewer banks
in the nation and, thereby, decreased competitiveness in banking. Underlying this concern is
the assumption that the relevant determinant of

competitive vigor is the total number of banking
firms in the whole country. Most banking economists believe that the relevant market for most
consumer or retail banking services is much
smaller than the nation.
As a result, even if interstate provisions were
to decrease the number of banking firms in the
whole country, they would not necessarily decrease the number of banking firms within the
relevant market. For example, without interstate
banking, adifferent set of three BHCs, for a total
of 15, may serve each of five one-state areas.
With interstate banking, there may be a total
of only 10 BHCs in the five-state region, but
all ten would serve each state.
Fewer bank failures?

A decrease in the probability of bank failures
is yet another possible benefit of the market
expansion that arises from interstate banking or
branching. Risk is "diversifiable" to the extent
that the expansion of business opportunities improves the tradeoff between risk and expected
return faced by banks. The improvement comes
in the form of lower risk for a given expected
return, or a higher expected return for the
same risk.•'
In an expanded geographical market, many
of the new combinations of risk and expected
return open to a bank are likely to yield a lower
probability of bank failure. In principle, a bank
that geographically diversified its assets to
reduce risk would face a lower probability
of insolvency.

Whether an interstate bank would choose a
combination of risk and expected return that
reduced its probability of insolvency would
depend on a number of factors. Among those
factors are the bank managers' incentives, which
may be affected by the existing system of deposit
Another factor is the effect of any diversification
on operating costs. A pure portfolio investor who
holds assets only passively can decrease the
probability of insolvency by diversifying assets
to reduce risk. Bank loans, however, are special
types of assets that also require administrative
input, and, more importantly, monitoring of
covenants and terms. When a banking firm

diversifies assets, the probability of insolvency
may rise because the pure portfolio effects are
outweighed by a deterioration in the ability to
administer and monitor varied and dispersed
loans. The term "operating risk" refers to the
latter effects.
Using a sample of banking organizations
with differing levels of geographic dispersion,
economists Nellie Liang and Stephen Rhoades
investigated whether the effects of increased
operating risk outweighed the portfolio effects
of diversification. Specifically, they examined
whether the effects of an increase in operating
risk on the level of earnings outweighed the
effects of an increase in pure "financial diversification" on the variability of earnings in
such a way that they increased the probability
of bank failure.
Liang and Rhoades' empirical results supported
the conclusion that geographic dispersion does
reduce the probability of bank insolvency. However, they cautioned that operating risk appears
to influence the probability of bank failure significantly, and should therefore not be discounted
in any assessment of the effects of bank portfolio
diversification. Although the more geographically dispersed banking firms had lower earnings
variability, they also had lower earnings levels,
which Liang and Rhoades attributed to the
effects of operating risk.
Thus, banking firms that take advantage of
interstate banking and branching to increase the
geographic scope of their market are likely to
reduce their probability of insolvency, although
not by as much as standard portfolio theory
would predict.
What experience tells us

The evidence presented so far seems to indicate
that interstate banking and branching do offer
potential benefits. Whether banks can reap these
benefits is an empirical issue.
Some studies have addressed the question of
whether interstate banking organizations enjoy
some competitive advantage over banking organizations that do not operate on an interstate
basis. Most of them indicate that interstate banking firms do not enjoy any long-run competitive
advantage over non-interstate banking firms of

comparable size. This finding is consistent with
the evidence cited above indicating that synergies related to an expanded scope of activities
contribute relatively little to efficiency.
Evidence pertaining to the relationship between
the geographic dispersion of bank offices and
actual bank failures can be found in the work of
economist Hilary Smith. Using data from actual
bank closures, Smith found empirical evidence
that intrastate branching restrictions, which limit
branching to a confined area, increase the incidence of bank closure. One may extrapolate
from this result to say that interstate branching
and banking provisions would decrease the
probability of bank closure. However, no one
has yet investigated the degree to which banking
firms actually take advantage of existing interstate banking laws to widen their geographic
range. Further evidence on this issue is necessary
to assess fully the effect of interstate banking or
branching on bank performance.

the greater the number of states whose BHCs are
permitted to acquire in-state banks. This suggests
that the market perceives interstate laws to enhance competition and to erode excess profits
previously protected by geographic restrictions.
The results of this preliminary work do not rule
out the idea that interstate operations may reduce
insolvency by allowing greater asset diversification. Diversification opportunities would likely
encourage stock returns to respond positively
to interstate banking laws. Potential acquisition
targets would see their stock price bid up in
anticipation of the higher acquisition price that
out-of-state acquirers, with more to gain through
geographic diversification, would pay. The overall negative response of bank stock returns merely
suggests that the negative effects of increased
competition on all bank stocks outweigh the
positive effects for possible acquisition targets,
if any exist.

Interstate branching
Evidence from bank stock returns
Examining the response of the stock returns
of BHCs to the passage or enactment of interstate banking laws offers an alternative means
of assessing the possible effects of such laws.
Although such an approach can only provide
information on the market's perception of
possible gains or losses, it offers an important
advantage over direct comparisons of interstate
and non-interstate banking firms. Namely, it
provides evidence on the effect of interstate
provisions on the entire banking market. Such
evidence is especially important for determining
the effect on competition in the banking market.
Preliminary work at the Federal Reserve Bank
of San Francisco indicates that BHC stock returns
have shown a statistically significant negative
response to the implementation of interstate
banking laws since the late 1970s. Laws permitting out-of-state BHes to acquire in-state banks
appear to reduce the stock returns of in-state
BHCs. Moreover, the negative effect is stronger

Because very few states permit out-of-state
banks to set up or acquire branches in their state,
we can only infer the potential effects of further
geographic liberalization from what we know
of interstate banking today.
The available evidence, including preliminary
empirical evidence gathered at this Bank, indicates that the main benefits of interstate operations stem from increased competition. There
appears to be little reason for concern that interstate branching would lead to the demise of
small banks. As found by Berger and Humphrey,
efficiencies due merely to bank size or scope
of operations are relatively insignificant when
compared with the benefits of efficient management. If interstate branching were to become a
reality, we could expect it to enhance competition further and to encourage the efficient
management of banks of all sizes.

Elizabeth laderman

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120